The price that a regulated access
provider charges for shifting customers between service providers has
significant welfare implications. Typical regulatory approaches to
pricing, such as pricing based on fully allocated cost or incremental cost,
ignore the characteristics of consumer demand. A theoretical alternative,
Ramsey pricing, considers only the elasticity of demand for given
products. This paper directs attention to the competitive process.
Using U.S. long-distance telephone services as an example, this paper shows how
empirical evidence concerning customer acquisition costs, customer switching
costs, and churn among service providers can help to inform price regulation.

I. Introduction

In regulated, infrastructure-based
industries such as electric power, natural gas, and telecommunications, policy
makers have taken, or are taking, steps to foster consumers’ ability to
change their providers of particular services. Economic issues
crucial to the welfare effects of such policies are often overlooked.
With an empirical and institutional focus on telecommunications, this paper
identifies issues and trade-offs that should be considered in regulating or
reviewing prices for shifting between service providers.

Fostering consumer shifting between
service providers has been an important aspect of telecommunications
policy. Policy makers have enacted rules and regulations to ensure that
consumers can shift between providers of certain services without having to
change their dialing behavior (MFJ 1982, App. B; FCC 1996a, Section II A. and
B; EC 1998a, Article 12(7)).[1] Policy makers have also enacted
regulations to ensure that consumers can change providers for certain other
services without having to change their telephone numbers (DTI 1991; FCC 1996b;
EC 1997, Article 12(5)). Regulatory policies to enhance consumers’
ability to shift among broadband internet service providers are beginning to be
debated (AOL 1998; Oftel 1998). Policy discussions have generally focused
on technical capabilities and legal rights associated with consumers’ changing
service providers, while pricing associated with such changes has often been
considered only as an afterthought.

The economics literature on switching
(shifting) costs might be interpreted to imply that pricing decisions are
simple. This literature shows that switching costs tend to create market
power, resulting in higher prices and less product differentiation (Klemperer
1995; Padilla 1996; Sharpe 1997; Chen 1997). Klemperer (1995, 516)
argues that public policy “should seek to minimize switching
costs.” Regulators might interpret this analysis, in conjunction with
typical costing principles, to imply that a regulated network operator’s price
for changing a customer’s service provider should be set at its incremental
cost of making such a change (ACCC 1998).[2] However, this
prescription assumes the merits of competition for the given services. In
pro-competitive regulatory policy, service definitions are often necessarily
the result of regulatory judgment about the importance of a particular type of
choice.[3] In addition, the economics
literature on switching costs does not clearly specify relevant, feasible policy
options or tradeoffs. Without situation-specific knowledge it is
difficult to do so.

Pricing decisions are in fact not
simple, and rather than being an afterthought, pricing should be a central
issue in any decision to promote shifting between service providers. A
decision on pricing indicates quantitatively the importance attached to
promoting a particular type of choice. Given the dynamism of
communications technology and the administrative challenges of implementing
effective regulation, making such a decision is necessarily a matter of
considered judgment informed by accumulated experience and quantitative
evidence.

This paper provides tools to help
inform regulatory judgment about prices for shifting between service
providers. Section II describes some institutional
background. Section III presents a simple theoretical model useful for
understanding the welfare implications of policies that affect the cost of
shifting between service providers. Section IV documents relevant empirical
characteristics of consumer shifting among U.S. long-distance telephone service
providers. Section V shows that a modified version of the model in
Section III provides a useful tool for quantitative analysis of policy
alternatives. Section VI offers conclusions.

II. Institutional Background

The equal access requirements imposed
in the Modified Final Judgment of U.S. v. AT&T [MFJ, 1982] have been an
influential model for policies to foster consumers’ ability to change service providers
in telecommunications and other regulated, infrastructure-based
industries. The MFJ required that customers be able to choose and change
their interLATA service providers without changing either their dialing
behavior or the network operator that provides their local connection to the
public telecommunications network.[4] This equal
access requirement essentially defined what is now commonly known as
long-distance service in the U.S. It also implied that the network
operator providing local access provides an additional service: maintaining and
updating information on a customer’s interLATA service provider so that
interLATA calls can be routed to that carrier. This regulated
service provided by the local access operator is known as carrier pre-selection
for long-distance service.

While considerable attention was
focused on the importance of providing equal access, much less attention was
devoted to the charge for changing long-distance carriers. After rejecting
as inadequately justified a proposed charge of $26.21 for changing the
presubscribed [pre-selected] long-distance carrier, the FCC stated:

A
presubscription charge that covers the unbundled cost of a subscription change
would be reasonable. Also, to the extent that a presubscription charge is
intended to discourage excessive amounts of shifting back and forth between or
among interexchange carriers, we do not believe a charge geared to this purpose
would be unreasonable. Absent proper cost support for presubscription
charges, we believe a charge of $5 per change (after one free preselection)
would be reasonable. It would reflect some cost recovery and would not
pose a barrier to competitive entry or exercise of consumer choice.[5]

Most local exchange companies chose to tariff a pre-selection
change charge of $5, and this charge, with a few exceptions, has remained
constant since 1984.[6]

Equal access arrangements have
subsequently been extended to a much broader and less well-defined set of
services. The U.S. Telecommunications Act of 1996 requires all
local exchange carriers to provide dialing parity and non-discriminatory
access to competing providers of telephone exchange service and telephone
toll service.[7] The FCC has provided some
guidance as to what categories of services should be grouped together for
pre-selection purposes.[8] It has also ruled that the costs
and prices for these additional arrangements be evaluated within the same
framework of national rules established for the recovery of number portability
costs.[9] Individual states within
the U.S. have been defining the pre-selection mechanisms and associated prices
required by the Telecommunications Act of 1996. These prices are
generally greater than zero and vary across states. The relationship
between these state-level developments and the national framework that the FCC
set out is not clear.

In Europe there has also been a
policy emphasis on equal access arrangements with little systematic
consideration of pricing policy and market structure. The European
Union’s Interconnection Directive, as amended, requires organizations
operating public telecommunications networks and having significant market
power to provide by 1 January 2000 access through pre-selection and a short
call-by-call prefix to the switched services of any interconnected provider of publicly
available telecommunications services.[10]
Determining the number and scope of pre-selection options, which plays an
important role in structuring service markets, has been left to the member
states.

With respect to pricing, the EU’s Interconnection
Directive offers only very general guidance:

National
regulatory authorities shall ensure that pricing for interconnection related to
the provision of this facility [carrier selection] is cost-oriented and that
direct charges to consumers, if any, do not act as a disincentive for use of
this facility.[11]

The requirement that charges be “cost-oriented” appears to be
weaker than a requirement that charges be “cost-based”, a requirement which
itself requires considerable interpreting rules. Moreover, whether this
charge is made directly to the consumer or to the carrier acquiring the
consumer is not necessarily economically relevant,[12] and
any charge necessarily acts as a disincentive for use of the service.[13]

Over-all, the current institutional
framework for regulating prices for shifting between service providers consists
of two principles and some qualifying concerns. The first principle
is that promoting consumers’ ability to choose different providers for a given
service is pro-competitive and hence desirable from a welfare
perspective. The second principle is that cost is the appropriate basis
for regulating a network operator’s price for changing a customer’s
pre-selected service provider. The qualifying concerns associated with
these principles, namely, the incentive effects of pricing and the implications
for customer churn among service providers, could help to contextualize these
principles, but they have been largely overlooked. The success of the MFJ
in stimulating telecommunications competition in the U.S., the strong
ideological push for competition around the world, and the force of traditional
cost-based regulatory practice has lead to policy principles that have abstract
merit but that lack well-analyzed connections to industry realities.

III. A Simple Model

Consider an infrastructure-based
industry with two competing retail service providers and a regulated network
operator.[14] The upstream network operator
provides two services to the downstream retail service providers: a network
service, which is a component of the retail service providers’ marginal cost,
and a change service that changes a particular customer’s retail service
provider. With respect to telecommunications, the network service might
be thought of as a per-minute fee for originating and terminating long-distance
calls over a customer’s local access line, while the change service changes a
customer’s pre-selected long-distance service provider.

The (unregulated) retail service
providers compete for a fixed number of retail customers. Thus a service
provider gains new customers only by inducing customers to shift from the other
service provider. Each service provider can offer its new customers a
price pn different from the price pcthat
its current customers are paying. Assume that service costs are constant
per customer. Then the retail market essentially decomposes into two
markets: the market for one service provider’s current customers and the market
for the other service provider’s current customers. Assume that both
service providers have the same costs. Then the price for new customers and the
price for current customers do not vary across service providers. In
particular, they do not depend on a service provider’s market share.[15] Moreover, without loss of
generality, assume that retail service providers have no costs other than the
costs associated with purchasing network services and change services from the
network operator.

Consumers choose only whether to
change service providers. Each consumer has a reservation value r for
a unit of service,and a customer that consumes the service consumes
exactly one unit of the service. Consumers’ costs of changing providers
are uniformly distributed over [0,u] with u>0.[16] Given that pc
and pn are less than r, the fraction of current
customers shifting to a new service provider is

(1)

Consumer welfare is

(2)

where the last term on the right side of (2) represents total
consumer shifting costs.

The network operator is assumed to be
subject to price regulation. Its costs will be assumed to be costs that,
from a regulatory perspective, must be recovered under non-confiscatory
regulatory policy. These assumptions imply that changing one of the
network operator’s prices without a revenue-neutral change in the other price
will not be considered a feasible policy option. Let s be the
network operator’s marginal cost of changing a customer’s service provider.[17] Let m be the regulated
price per unit of service such that m and s are compensatory
(feasible) prices for the network operator.[18]
With this set of prices m recovers all of the network operator’s fixed
costs. Alternative feasible prices for the network operator are
parametrized by ta and ts, where the
network service price is m-ta per unit of service and the
network operator’s price for changing retail service providers is s+ts.

Revenue neutrality implies

(3)

To ensure that consumers will purchase the good and that
changing service providers is feasible for all consumers when the service price
is m, assume

(4)

In the market for a given service provider’s current
customers, the given service provider chooses a profit-maximizing price for current
customers. The other service provider chooses a profit-maximizing price
for its new customers, which it attracts from the given service provider’s
current customers. The regulator is assumed to set the network operator’s
prices in advance of the retail service providers’ pricing decisions.

Note that (1) implies that the gain from attracting new
customers with a price reduction is proportional to 1/u, while the cost
to shift a new customer is s+ts. If , the gain is not
sufficient to offset the cost, and no shifting occurs in equilibrium (D=0).
Given the network operator’s (regulated) prices for network service and for
shifting customers, the Nash equilibrium retail prices for the service
providers are

(7)

Since in this simple model there is
no price elasticity of demand, social welfare is maximized whenever the retail
prices are at or below consumers’ reservation value and no consumer shifting
between service providers occurs. In particular, social welfare is
maximized at the monopoly prices . Social welfare is also
maximized when ts is set such that , which from (7)
and (4) implies . Note that since in this
equilibrium no consumer shifting occurs, no retail service provider ever pays
the shifting price s+ts, and (3) implies ta
= 0. Nonetheless, because the shifting price determines the intensity of
competition, by regulating the shifting price the regulator affects the service
price. More generally

Proposition 1:The presence of competing service providers can benefit
consumers even without any socially costly consumer shifting between service
providers.

This result is similar to results from the contestable
markets literature.

Shifting Between Retail Service Providers Occurs in
Equilibrium (Case 2):

If , retail service providers have an
incentive to raise prices for current customers above the level in (7).
This causes some current customers to shift. The Nash equilibrium prices
are

(8)

The share of consumers shifting between service providers is

(9)

Regulators or governments might be
willing to accept the social costs of some consumer shifting in order to
maximize consumer welfare. To find feasible network operator prices
that maximize consumer welfare, substitute (8) and (9) into (2) and maximize
with respect to ts. If , the cost allocation that
maximizes consumer welfare is

(10)

Since u>0, the cost to service providers of acquiring a
new customer is .[20]

Proposition 2:Consumer welfare is not maximized by setting the network
operator’s price for changing service providers at its marginal or incremental
cost of making such a change (ts=0). The magnitude of the
network operator’s marginal cost of changing a customer’s service and
consumers’ costs of shifting service providers also affect the optimal price
for shifting.

While the above results depend on the
specific structure of this model, the important point is that the marginal cost
to the network operator of changing a customer’s service provider should not be
the only factor in a regulatory review of the network operator’s price for this
service. The intensity of service-provider competition, the magnitude and
nature of service providers’ customer acquisition costs, and consumers’ own
costs of shifting between service providers are also relevant.[21] The above model shows that the
optimal shifting price is always below the network operator’s marginal
cost. With a more complicated specification for consumers’ shifting costs,
the result could go the other way.

IV. U.S. Long-Distance Telephone Services

This section will review basic features of long-distance
service competition in the U.S. and examine, for the U.S., costs to
long-distance service providers of acquiring customers, costs to consumers of
changing service providers, and the extent of consumer shifting among service
providers. While many countries are just beginning to
experience competition in long-distance services, such competition has existed
in the U.S. for over 15 years. The U.S. thus provides a good empirical
record for considering how shifting costs can affect the development of
competition.

Residential long-distance service
competition in the U.S. consists primarily of competition to acquire service subscribers
who are charged prices in accordance with tariffs filed but not reviewed at the
FCC. Consumers choose a presubscribed long-distance service provider to
provide all their “direct dialed” long-distance calls. Companies compete
to acquire such subscribers through a variety of discounts and
promotions. Consumers can change their presubscribed long-distance
service provider at any time, and service providers can change the terms of the
agreement with their customers at any time by filing new tariffs at the FCC.[22] In 1997, presubscribed
residential long-distance service revenue amounted to about $26 billion.[23]

Other forms of long-distance service competition
are possible but currently much less economically significant in the U.S.[24] Call-by-call “dial around”
competition is increasing but still accounts for only about $2 billion of
consumer long-distance service revenue.[25] Long-distance
competition via prepaid calling cards is similar to dial-around competition but
features a different payment mechanism. Prepaid calling cards amount to
about $1 billion in consumer long-distance service revenue (FCC 1998b, table
6). “Toll-free” service shifts billing and the locus of competition from
the calling party to the called party but shares with presubscription an
ongoing relationship, governed through tariffs, between the service provider
and customer. Revenue associated with toll-free service, which is
sold predominately to businesses, probably amounts to about $14 billion.[26]

The FCC regulates the price that
local exchange (access) providers charge for switching a customer’s
long-distance service provider. Since 1984 most U.S. local exchange lines
have incurred a charge of $5 for changing the presubscribed long-distance
service provider.[27] Table 1 shows some
international comparisons. The German experience shows the potential for
conflict. In December 1998 Deutsche Telekom (DT) proposed a change charge
of DM 94.99 ($57.57) to go into effect January 1998. This proposal
generated a public outcry and a European Commission investigation. Six
months later the German regulator prescribed change charges that fall to DM 10
($6.06) by the year 2000. DT remains highly critical of this decision and has
found support within the German government (Boston 1998; Dow Jones Newswires
1998). Nonetheless, DT’s change charge is still significantly higher than
charges in the U.S. and other countries.

Table 1

Access Operator’s Charge For Changing
Long-Distance Service Provider

Place

Fee

Details; Source

Survey of 35
countries

DM 3-10
($1.81-6.06)

reported by
German regulator (TR 1998)

Chile

0

no fee for one
change per month; local expert

Finland

prob. $50-100

charge to
service provider, no charge expected to consumer; local expert

Germany

DT's
Dec. '97 proposal

DM 94.99
($57.57)

EC 1998b

DT's
Jan. '97 proposal

DM 49 ($29.70)

“

DT's
Apr. '97 proposal

DM 49 in 1998
($29.70)

DM 35 in 1999
($21.21)

DM 20 in 2000
($12.12)

“

Regulator’s decision

DM 27 in 1998
($16.36)

DM 20 in 1999
($12.12)

DM 10 in 2000
($6.06)

TR 1998

Israel

$3.00

set by Ministry
of Communications; local expert

UK

prob. $5-8

local expert

US

BellSouth

$1.49

FCC Tariff

SNET

$2.30

FCC Tariff

Pacific
Bell

$5.26

FCC Tariff

US West,
Ameritech,

Bell
Atlantic, SWBT

$5.00

FCC Tariff

Note: The figures in this table
have been collected from a variety of sources and should not be considered definitive.
Values are US dollars, as reported, or calculated at US$0.606/DM.

Long-distance service providers spend
a large amount of money on advertising and promotions to acquire long-distance service
customers. As table 2 indicates, total advertising and promotional
expenses associated with long-distance service in 1997 were approximately $5.4
billion, or $34 per presubscribed line in the U.S.[28] Total
advertising and promotional expenses have been growing about 22% per year in
real terms between 1988 and 1997. Competition has transformed
long-distance service from a utility into an industry that advertises at a rate
similar to food manufacturers and retailers of furniture and home furnishings
(Galbi 1999, table 6).

Source: Galbi (1999, table 3 and
ft. 7). The adjustment to 1997 values is based on the CPI for urban
wage earners and clerical workers.

The costs that consumers incur to
switch between long-distance telephone service providers are hard to quantify
but appear to be significant. In a survey examining incentives to
dial-around, 50% of respondents required at least a 20% savings to induce them
to indicate that they would dial-around their presubscribed long-distance
carrier (Schiela 1998).[29] Since the capitalized
value of a 20% savings on the median U.S. long-distance bill is about $700,[30] consumers respond as if the cost to
them of changing their calling behavior is rather high.

Evidence with respect to local service
providers indicates that the issue is not simply the nuisance of dialing
additional digits to complete a dial-around call. In a well-documented
survey conducted about December 1994, only 56% of residential local access
customers indicated that, given a 25% discount and number portability, they
would choose their current long-distance service provider as their local
service provider, and an even smaller fraction indicated that they would be
interested in any other provider (Constat 1995, p. 15).[31]
This same survey found that 63% of residential consumers had never switched
their long-distance service provider (Constat 1995, p. 25).

Consumers may perceive significant
costs associated with acquiring and effectively analyzing information about
service providers. A survey indicates that in March, 1998, 10% of
consumers could not correctly identify their long-distance service provider
(Insight Research 1998). There is ample additional evidence that consumers
have to invest significant time and attention to evaluate competing offers for
long-distance service.[32]

While a significant share of
consumers apparently have relatively large costs of shifting between service
providers, there can be a large return for changing carriers.
Long-distance service providers offer prices that differ by more than 100% for
the exact same communication service. Moreover, for international calls
price dispersion is an order of magnitude greater. In the mid-1990s the
major long-distance carriers often gave desirable customers large cash bonuses
for switching to them, and some consumers switched carriers repeatedly to
benefit from these bonuses. AT&T recently shifted to offering free
minutes rather than cash bonuses. This change is reflected in AT&T’s
reduction in advertising and promotional expenses from 1996 to 1997 (see table
2). Carriers have also established loyalty plans tied to airline
companies’ frequent flyer programs. Nonetheless, by switching
long-distance providers, consumers can achieve savings on the order of 20% of
their long-distance bill.

The number of consumer shifts between
long-distance service providers has increased dramatically since the early
1990s. Table 3 shows for the state of Connecticut the number of changes
in consumers’ presubscribed long-distance service providers relative to the
number of presubscribed lines. The 51.8% figure in Connecticut in 1996 is
close to the 48.4% figure for the Ameritech region in 1996.[33]
These statistics should not be interpreted to mean that half of long-distance
consumers changed companies in 1996; some consumers change companies multiple
times. One study indicates that the median amount of time that a household
that switches its long-distance service provider stays with that provider is
235 days (Williamson, Goungetas and Watters 1997).[34]
On the other hand, some consumers do not switch at all. In early 1996,
16.4%, 39.0%, and 33.8% of AT&T, MCI, and Sprint customers, respectively,
reported having changed their long-distance carrier in the previous 12 months
(PNR 1996).

Table 3

Long-distance Service Provider Churn

In Connecticut

year

% changes/lines

1991

5.8%

1992

11.7%

1993

15.3%

1994

23.3%

1995

38.4%

1996

51.8%

1997

39.3%

Note: The number of
long-distance service provider changes is estimated from revenue figures in SNET’s
FCC Report 492A and SNET’s tariffed price for changing service
providers. SNET’s presubscribed line count is from FCC (1998c, Table
10.2). SNET provides 99% of presubscribed lines in Connecticut.

While analysts have argued vigorously
about long-distance competition in terms of a description of a state (“Is the
long-distance market competitive?”) (Kahai, Kaserman, and Mayo 1996; MacAvoy
1996; Taylor and Zona 1997), the competitive process in long-distance service
provision is itself economically significant. Long-distance service
providers spend large amounts of money to acquire subscribers. Consumers
recognize significant costs associated with changing providers. The
observed outcome is significant consumer shifting between service providers in
conjunction with a widely expanding array of bonuses, promotions, and marketing
angles. The effect of a regulated price for executing a consumer’s order
to change service providers should be analyzed in light of these features of
the competitive process.

V. An Empirical Model

This section will modify the
model presented in Section III so that it incorporates available empirical
evidence, including the type of empirical evidence presented in Section
IV. A disadvantage of doing so is that the model becomes analytically
intractable and must be solved numerically. However, because the model
then incorporates key quantitative facts in a disciplined way, it provides a
useful tool for quantitative analysis of the effects of changes in the price
for shifting between service providers.

As in Section III, the model will
analyze competition for one service provider’s current customers.
Competition for the other service provider’s current customers will give a
symmetric result, and total profits and consumer welfare do not depend on the
market shares of the two service providers (Chen 1997). Consumers are
assumed to consume telephone service q and another aggregate good whose
price per unit is normalized to one dollar. Consumers are assumed to have
an indirect utility function

(11)

where p is the price of telephone service and y
is income, both denominated in dollars. This indirect utility function
implies that the demand for telephone service has constant elasticity e.

(12)

The service provider with the
customer base sets a price pc for its customers. The
competing service provider sets a price to attract those customers as
new customers. In addition, the service provider seeking new customers
also chooses a level of expenditure A on advertising and
promotions. The service provider with the customer base responds with
expenditures rA on its own loyalty and winback campaigns, where r
is an advertising response parameter.[35] The share of
consumers that switch from their current provider to the new provider is a
function of advertising and promotional
expenses and prices, such that and .[36]

The network operator is considered to
be a fixed-cost business in which the regulator imposes for purposes of cost
recovery prices that have marginal effects downstream.[37]
Let s+ts be the retail service providers’ marginal cost of
acquiring a customer, and let m-ta be the retail service
providers’ marginal cost of serving a customer. Components of these
marginal costs are, respectively, a regulated price that the network operator
charges for changing a customer’s retail service provider, and a regulated price
that the network operator charges for network services.[38]
As before, tsand ta parametrize the
regulator’s ability to affect the regulated service price and the price for
changing service providers. Revenue neutrality implies

(13)

The profit functions for the two
service providers are

(14)

(15)

The first-order conditions for profit maximization imply

(16)

(17)

(18)

While it is difficult to estimate the
whole function D, a log-linear local approximation can be estimated
using available empirical information and the above first-order
conditions. In particular, let

(19)

(20)

With empirically appropriate values for prices, demand,
costs, and churn at ts=ta=0, the first-order
conditions can be solved for kA, kc, and kn.

To illustrate a calibration of the
model, consider U.S. residential presubscribed long-distance service in 1997.[39] In 1997 there were 96.1
million U.S. households with telephones (FCC 1999, table 17.1) and $26 billion
in residential presubscribed long-distance service revenue.[40]
A reasonable estimate for long-distance minutes billed to residential
households in 1997 is 127 minutes per household per month.[41]
These figures imply an average price per minute for residential long-distance
service, including international service, of 17.8 cents.[42]
Taking 20% as an estimate for the discount offered to attract new customers
implies, in conjunction with the churn estimate below, pc=18.8
cents and pn=15.0 cents. The marginal cost m of
long-distance service consists primarily of per minute originating and
terminating network service costs, including international termination costs
(settlement rates). For 1997 these costs averaged 9.4 cents per minute
(FCC 1998b, table 5).

Information on advertising expenses
and churn is important to the model. Table 2 indicates that
advertising and promotional expenses amounted to about $56 per U.S. household
with a telephone in 1997. The churn data indicate that D=.25
is realistic. The model implies that the two service providers have the
same total advertising and promotional expenses (1+r)A.
If the service providers are assumed to have market shares of 60% and 40%,
respectively, than the larger service provider will spend 33% less per customer
on advertising than the smaller service provider. Table 2 shows that
AT&T spent 69% less per customer than the rest of the industry in 1997.
Thus the model clearly falls to capture some important aspects of industry
advertising and promotion dynamics. But it is worth noting that r
affects only how total industry advertising is calibrated. Thus without
loss of generality assume r=1.

Separate estimates for s and A
are more difficult to produce. In the U.S., local exchange carriers
(network operators) generally charge $5 for changing a customer’s presubscribed
long-distance service provider, and long-distance service providers generally
pay this fee for their customers. Long-distance carriers also bear
additional costs for setting up a new customer, and some advertising and
promotional expenses may be directly linked to acquiring customers.[43] The parameter s
includes the network operator’s charge for changing the customer’s
long-distance provider as well as other customer acquisition costs that the
long-distance provider incurs on a per-customer-acquired basis. The parameter A
includes expenses for customer acquisition, such as advertising, that are not
incurred on a per-acquired-customer basis. Reasonable estimates for s
and A are s=$20, A=$26.34.[44]

Information relating to the utility
function and the demand function is also important. The elasticity of
demand for long-distance service in the U.S., the parameter e, is about
-0.7 (FCC 1988, Attachment C). Median household income in the U.S. in
1997, the parameter y, was $37,005 (Census Bureau 1998, Table
A). This information, along with the price and quantity estimates
above, is sufficient to parametrize the utility function V and the churn
function D. The number of households with a telephone in 1997,
96.1 million, is used to scale the model.

The model is solved in two
stages. First, given the empirically relevant values for pc,
pn, D, and ts=ta=0,
(16)-(18) are solved for kA, kc, and kn.
With these parameters anda change in ts (associated
via (12) with a change in ta), the model is solved for new
values of pc, pn, and D. As
table 1 indicates, a change of plus or minus $3 in the price for shifting
between service providers, given a prevailing price of $5, would not be unusual
in light of current practices. Table 4 shows the effects of a $3
reduction in the shifting price; an increase produces similarly sized effects
in the opposite direction.

Despite the fact that the network
operator’s marginal cost of shifting customers between service providers is
zero, a reduction in the network operator’s price for changing service
providers reduces total welfare. Lowering the price for changing service
providers decreases service prices and increases advertising spending and
consumer churn. These effects all lower service provider
profitability. In the base case, a $3 (network operator revenue neutral)
reduction in the price for changing reduces total service provider
profitability (including advertising expenses) by $280 million. For
consumers, the benefits of lower service prices are partially offset by the
cost of increased churn. The cost to a consumer of changing service
providers has been estimated as the income (compensating variation) necessary
to make the consumer indifferent to shifting between service providers.[45] The total benefit to consumers
amounts to $282 million. The total welfare effect is a gain of $2
million. Raising the price for changing produces essentially opposite
effects.

Table 4

Effects of a
$3 Reduction in the Price for Switching Service Providers

Variant Parameter

Base Case

E=-1.4

m=0.06

s=10

s=30

% Change

current-consumer
price

-1.06%

-2.50%

-0.72%

-0.87%

-1.35

new-consumer
price

-1.16%

-0.63%

-1.33%

-1.13%

-1.18

Advertising

2.06%

9.10%

1.20%

1.81%

2.42

churn

1.55%

7.07%

0.76%

1.32%

1.90

Change in million US$

total profits

-$280

-$663

-$156

-$235

-$347

Advertising

$104

$461

$61

$92

$122

Consumer
welfare

$282

$517

$225

$242

$341

Shifting costs

$23

$108

$11

$20

$29

sum of firm and
consumer effects

$2

-$147

$69

$7

-$6

The effects of a change in the price
for changing service providers depend on the model parameters. Doubling
consumers’ elasticity of demand more than doubles the change in consumer welfare
and firms’ profits, and the over-all welfare effect turns negative. The
effects of a reduction in the shifting price are like the effects of a tax: the
welfare effects are greater the more elastic is demand. Lowering m
generates a parametrization with a higher price-cost margin for service
providers.[46] Such a change appears to
soften the competitive response to a reduction in the shifting price, but
improves total welfare. These effects can be reconciled by recognizing
that, as is the case for a tax, welfare losses are generally proportional to
the square of the price-cost margin. Thus with a higher price-cost
margin, a given price reduction has greater welfare benefits. The
results with respect to service providers’ customer acquisition costs are
surprising. With respect to total welfare, higher acquisition costs make
a (network operator revenue neutral) reduction in these costs less
desirable. But higher customer acquisition costs make a reduction
in these costs more desirable in terms of consumer welfare.[47]

Because the profitability of current
and new customers is different, the profitability of the two service providers
depends on their shares of current customers. Table 5 shows how
service-provider-specific effects depend on market share. While the total
reduction in profits is constant, the service provider with a greater market
share experiences a larger share of the reduction in profits. The intuition
is straight-forward: policies that lower service-providers’ costs of acquiring
customers are more costly to service providers that currently have a larger
market share.

Table 5

Distribution of Profit Impact Between
the Service Providers

Industry Evolution

Scenario 1

Scenario 2

Scenario 3

Scenario 4

Initial share
of consumers (firm 1)

100.0%

85.0%

60.0%

50.0%

Final share of
consumers (firm 1)

64.2%

60.0%

52.8%

50.0%

Change in Profits with ts = -$3 (mil.
US$)

Firm 1

-$266

-$228

-$165

-$140

Firm 2

-$14

-$52

-$115

-$140

VI. Conclusions

While regulators have tended to require
incumbent network operators’ interconnection charges to be cost-based or
cost-oriented, regulators should consider factors in addition to incumbents’
costs in determining the most socially desirable charges. Service
providers’ customer acquisition costs, the cost to customers of changing
service providers, and the level of churn are important factors in evaluating
the welfare effects of a network operator’s charge for shifting customers
between service providers. At a conceptual level, considering these
factors helps regulators to focus on specific benefits of real competitive
processes. In assessing empirical significance, a model such as that
offered in this paper serves as a useful tool for disciplined, quantitative
analysis. Considering factors in addition to incumbents’ costs is
not simple, but neither is analyzing incumbents’ costs. Both types of
analysis should play a role in a reasonable, open, and effective regulatory
process.

Recognizing the costs that switching
service providers imposes on service providers and customers should encourage
policy-makers to promote ways in which customers can obtain service and price
improvements without switching service providers. As Hirschmann (1970)
points out, an alternative to exiting from a relationship with one service
provider and switching to another is for customers to communicate, with words
rather than merely with exit choices, their needs, expectations and
frustrations. Promoting diverse, effective channels for customers’
voices should be considered as part of liberalization and de-monopolization
policies in infrastructure industries.

The empirical model in this paper
shows that the price for changing service providers has a much larger effect on
the distribution of surplus between consumers and service providers than it
does on total welfare. This result points to trade-offs that
regulators need to consider in assessing goals for competitive development and
industry structure. When service providers have significant sunk costs
and provide a wide range of services, the overall division of surplus between
consumers and service providers may not be directly related to the division of
surplus for a particular service. For example, service providers
competing in terms of adding new services to a service package could dissipate
profits from providing well-established services. Alternatively, service
providers might sacrifice surplus in a well-established service, such as basic
internet access, in order to gain value in new services. The desirability
of shifting the division of surplus for a particular service needs to be
considered relative to the priorities of a particular pro-competitive strategy.

References

ACCC [Australian Competition & Consumer
Commission]. 1998. Pricing Principles for Local Number
Portability. Available on the web at
www.accc.gov.au/contact/portability/index.html.

AOL [America Online]. 1998. Comments In
the Matter of Joint Application of AT&T Corporation and Tele-Communications
Inc. for Transfer of Control to AT&T of Licenses and Authorizations Held by
TCI and its Affiliates or Subsidiaries. FCC CS Docket No. 98-178
(October 29): available on the web at www.fcc.gov/ccb/Mergers/ATT_TCI/.

AT&T. 1998. Annual Report for
1997. Available on the web at www.att.com.

Cluny, John. 1997. “Number Portability in
the UK: A Two-Edged Sword?” Paper presented at the 1997
Telecommunications Policy Research Conference: available on the web at
www.si.umich.edu/~prie/tprc/abstracts97/cluny.pdf.

EC [European Commission]. 1997. Directive
97/33/EC of the European Parliament and of the Council of 30 June 1997 on
interconnection in Telecommunications with regard to ensuring universal service
and interoperability through application of the principle of Open Network
Provision (ONP). Official Journal No. L 199: 0032-0052.

EC. 1998a. Directive 98/61/EC of the
European Parliament and of the Council of 24 September 1998 amending Directive
97/33/EC with regard to operator number portability and carrier pre-selection.
Official Journal L 268: 0037-0038.

EC. 1998b. Commission terminates
procedure against Deutsche Telekom’s fees for preselection and number
portability and transfers the case to national authorities. Press
Release IP/98/430.

FCC. 1996a. In the Matters of
Implementation of the Local Competition Provisions of the Telecommunications
Act of 1996and other matters, Second Report and Order and
Memorandum Opinion and Order. CC Docket No. 9-98 (August 8), 11 FCC
Rcd 19393.

Klemperer, Paul. 1995. “Competition when
Consumers have Switching Costs: An Overview with Applications to Industrial
Organization, Macroeconomics, and International Trade.” Review of
EconomicStudies 62: 515-539.

Williamson, R.B. and J.S. Chen. 1997.
“Long-distance Churn: A Tobit Analysis.” Paper presented at the Fifteenth
Annual ICFC Conference (June), San Francisco: available on the web
at www.econ.ilstu.edu/icfc/prelim97.htm.

* The views expressed in this paper are
those of the author and do not necessarily reflect the views of the Commission
or its staff.

[1] Such policies are called carrier
preselection policies. Carrier preselection allows consumers to choose
the service provider for calls placed to (standardized) telephone numbers that
do not include service-provider-specific codes.

[2] Interconnection regulation typically
requires interconnection services to be cost-based. Interconnection
regulation may be interpreted to encompass carrier pre-selection and thus to
imply that carrier selection should be cost-based.

[3] For example, the MFJ established the
basis for long-distance telephone competition as competition for interLATA
telephone services.

[4] The MFJ defined 161 geographical
entities called local access and transport areas (LATAs) based on local calling
areas, natural geographic features, and state boundaries.

[8]In the Matters of
Implementation of the Local Competition Provisions of the Telecommunications
Act of 1996 (CC Docket No. 9-98) and other matters, Second Report and
Order and Memorandum Opinion and Order, 11 FCC Rcd 19393 (1996)
(released Aug. 8, 1996), Section II A. and B.

[9]Implementation of Local
Competition, 11 FCC 19440, para. 92. The FCC has put forward a price
structure for recovering the cost of number portability, and this price
structure has no charge for porting a particular customer’s number. See In
the Matter of Telephone Number Portability, Third Report and Order, CC
Docket No. 95-116, RM 8535 (rel. May 12, 1998), para. 87-92 and para. 135-146.

[10]Interconnection Directive
(97/33/EC), as amended by 98/61/EC, Article 12(7). These access arrangements
should be available in all EU Member States by January 1, 2000, although some
States have been granted an additional transition period. Some countries
have implemented carrier selection earlier than required by the EU.

[12] A basic economic principle in public
finance is that legal incidence does not determine economic incidence.
That means in this context that whether the charge is tariffed as an end-user
charge or as a charge for the acquring service provider is not determinative as
to who will pay the charge. In the U.S. the charge is nominally an
end-user charge, but carriers generally pay the charge on behalf of an acquired
customer. For an example of how a charge to a carrier can become a charge
to the end user, see the U.S. experience with PICC charges.

[13] EU Member States have the
responsibility for determining more exactly the meaning of
“cost-oriented”. In Germany, interconnection services are required to be
priced at long-run incremental cost under a Network Access Ordinance. In
Austria, interconnection services must be priced using a cost model that
calculated forward-looking long-run average incremental cost (FLLRAIC).

[14] The analysis in this section is
based upon the model that Chen (1997) used to evaluate allowing service
providers to pay customers to shift between providers. Paying customers
to shift is equivalent to discriminating between new and current
customers. U.S. long-distance service experience indicates that
forbidding such discrimination is not feasible for mass-market
services. Service providers can selectively inform consumers of
generally available prices so as to effectively pay customers to switch.
See Section IV.

[16] These shifting costs are costs that
customers themselves incur, while the network operator’s service provider
shifting charge is assumed to be paid by the acquiring service provider (as is
current practice in the US). Since each customer that shifts consumes
exactly one unit of the good, any bonus (or charge) to the customer for
shifting carriers could be assumed to be incorporated in the price for new
customers.

[17] The service provider that acquires
the customer is assumed to pay this charge. This is not an important
assumption. See above footnote.

[18] Since s is the marginal cost
of shifting a customer, the number of customers is fixed, and in
equilibrium each customer consumes exactly one unit of the service, s
and m can be determined without regard to the number of customers that
shift between service providers or the price of service.

[19] For Case 1, the first order
condition for Pc needs to be
evaluated at D=ta=0 to see that there is no incentive to
raise pc. Since there is no shifting in this
equilibrium, there can be no gain from lowering pc or raising
pn. Lowering pn below the price of
acquiring and serving a customer, s+ts+m, would create a
loss. The solution for Case 2 follows from solving the first order
conditions.

[20] If s>2u, the cost
allocation that maximizes consumer welfare is ts=u-s, with pc=pn=m+u.
The cost to service providers of acquiring a new customer is s+ts=u<s
in this case as well.

[21] Note that the above model assumes
that competition is intense, in the sense that without any costs associated
with shifting between service providers, competition between the two firms
would result in price set at marginal cost (Bertrand competition with
homogeneous products). Service providers customer acquisition costs have
been assumed to be zero in the above model. In terms of the model, those
costs have the same economic effect as the network operator’s costs in s.

[22] The FCC has been seeking to
eliminate the tariff process for long-distance service providers, but
long-distance service providers have mounted successful court challenges to
prevent detariffing.While there
has been a traditional concern that tariffs facilitate collusion, the advantage
of tariffs for U.S. long-distance service providers are primarily informational
and contractual: they allow service providers to change customers’ prices or
terms of service without directly informing customers. Moreover, a filed
tariff legally trumps a contract between the service provider and the customer
(the filed tariff doctrine).

[24] In contrast, in Chile long-distance
service competition consists primarily of call-by-call carrier selection, even
though preselection is also available at no cost.

[25] VarTec, the leading dial-around
provider, had $820 million in revenue in 1997 (FCC 1998, Table 1.2).
Schiela (1998) estimates that VarTec had 41% of dial-around revenue in
1997. This figure suggests that the dial-around industry has about $2
billion in revenue, a figure that agrees with a Yankee Group estimate cited in
Mehta (1998).

[27] BellSouth reduced its change charge
to $1.49 in 1990 on the grounds that automation has lowered its cost of
executing changes. MCI has filed complaints against other BOCs concerning
the level of their change charges.

[28] According to information that
AT&T presented in 1995, each person in the U.S. aged 18-49 was “touched”
(on average) approximately 330 times by a consumer long-distance sales message
in 1994, and AT&T, MCI, and Sprint had 3600, 4700, and 800
telemarketing representatives, respectively, in January 1995 (Clark and Murphy
1995).

[29] The percentage indicating that they
would use dial-around rises from about 40% with a 10% discount to about 65%
with a 50% discount.

[30] The median long-distance bill in the
U.S. is about $15 per month (FCC 1998a, Table 3.6). A 20% cost savings
thus amount to about $3 per month. The value of a $3 per month
savings, capitalized at a typical interest rate on short-term U.S. government
bonds (5%), is about $700.

[31] A survey in the U.K. provides
similar evidence (Cluny 1997). In addition, a large survey reviewed in
the trade press indicated that 78% of consumers wouldn’t change long-distance
providers for a discount of less than 10%, 57% wouldn’t switch for a discount
of 10-20% and 40% wouldn’t switch even with a higher discount (Turner 1998).

[32] The trade press has noted consumer
confusion concerning long-distance calling plans (Lawyer 1998). The FCC
and other groups have issued briefings and tools to help consumers evaluate
pricing plans.

[34] The sample covers 765 spells with
observed start dates. A study using the same data indicates that
long-distance carrier changes per presubscribed line rose from 19% to 64% from
mid-1992 to mid-1995 (Williamson and Chen 1997). These figures are higher
than other figures cited in the text and suggest that the sample may have
included consumers more likely to switch.

[35] This simple model focuses on
observed customer churn and includes only two prices: a price for current
customers and a (lower) price for new customers. The customer retention
strategy of “matching prices” should be interpreted within this model as a
loyalty or winback expense.

[36] Since r is exogenous, it will be
absorbed into the parametrization of D subsequently.

[37] Since in the U.S. telecommunications
industry, long-distance providers generally take customers’ orders to change
long-distance service providers and convey the order electronically to the
network operator’s information system, the marginal cost to the network
operator of shifting customers is much less than that of the retail service
providers. At least outside of a narrow busy period, the marginal service
cost in an infrastructure industry like telecommunications is close to zero.

[38] It is not necessary for the model to
separately distinguish these cost components.

[39] Note that the model is a static
model calibrated over a fixed period of one year. Estimating equilibrium
churn and average spell lengths raises much more difficult problems that are
not considered here.

[40] For the revenue figure, see Section
IV. The revenue and household figures imply average long-distance
household spending of $22.55 per month in 1997. For comparison, FCC 1998a
(table 3.6) gives a figure of $25.42. However, I consider the average
revenue per minute figures implied by FCC 1998a (table 3.6) and FCC 1998c
(table 15.2), 23.5 cents per minute, to be less plausible than that implied by
the figures used.

[41] FCC 1999 (table 1.4) gives 182.7
billion for originating interstate switched access minutes in 1997.
Originating access minutes are deflated by 1.07 to account for dialing and
call-setup time not billed by long-distance carriers. Mid-year 1997 presubsubscribed
lines are estimated at 160.8 million from FCC 1998c (table 10.2). The
number of presubscribed lines per household is estimated at 1.144 from the
ratio of non-primary residential lines to residential and single-line business
liness FCC 1999 (table 1.3). FCC 1998c (table 15.2) indicates that
interLATA intrastate residential minutes amount to 25% of interLATA interstate
minutes, and this ratio is used to inflate the interstate minutes to encompass
all interLATA minutes. These figures are the basis for the
estimated 127 minutes of long-distance calls per household per month. For
comparison, FCC 1998c (table 15.2) shows 108 minutes per month for residential
interLATA calling.

[42] For comparison, FCC 1998b
(table 5) shows 14.4 cents per minute for domestic and international toll calls
in 1997.

[43] In a study of interstate
long-distance rates and shifting between carriers, 1984-1993, Knittel (1997)
used the local phone company’s fee for switching long-distance carriers as a
measure of a consumer’s shifting cost. Between 1984 and 1990, all the
RBOC’s charged $5 for this service, while 1991-1993 only BellSouth charged a
different fee ($1.49). This means that all the variance in the fee
variable comes from the inflation adjustment. As the data in this paper
show, advertising and consumer churn have grown dramatically, and the price
that the local phone company charges for shifting a consumer’s long-distance
provider is only one of several factors that influence consumers’ shifting
costs

[44] Note that over-all customer
acquisition costs per customer served are T=sD+2A. A
was calculated as a residual based on values for T and s.

[45] The calculation thus implies that
the faction of consumers that change their shifting behavior are indifferent
between shifting and not shifting service providers.

[46] Note that the policy under
consideration is a revenue neutral change in the network operator’s price for
shifting customer between service providers and for providing per minute
network access.

[47] Note that customer acquisition costs
s are reduced by reducing one regulated component of these costs. See the
definition of s in preceding text. Changes in the base level of
churn (D=0.25) have relatively small effects on the results. For D=0.15,
the changes in consumer welfare and total welfare are $300 million and -$29
million, respectively. For D=0.35, the corresponding figures are $364
million and -$14 million.